Share Buybacks Are One Great Market Signal [Berkshire Hathaway Inc., Apple Inc., DST Systems, Inc.]

warren buffetIn the first four months of this year, U.S. companies bought back $255 billion worth of their own shares. That is no small sum, but it is significantly less than the $355 billion worth they purchased in the same period last year. The declining pace of buybacks has some analysts fretting that this is a bearish signal.

It’s not. The important question is not the aggregate amount of buying but rather “who is buying and how much?”

Academic studies have consistently found that the average stock not only rises immediately after the announcement of a repurchase program but continues to beat the market for several years.

The correlation between buybacks and stock outperformance is not hard to understand. There are two primary reasons. The first is when management feels so strongly that the company’s shares are mispriced that they are willing to invest hundreds of millions of dollars of the company’s money to repurchase the stock in the open market, they are essentially betting their jobs that the company’s shares are undervalued.

I say that because those responsible for the decision are unlikely to keep their seats in the boardroom if the stock finishes the buyback period significantly lower than it was at the beginning.

The other reason is mathematical. When you divide earnings by a smaller number of shares outstanding, you get higher earnings per share. And that’s what ultimately drives share prices northward.

Do Your Research

However, a little due diligence is in order. Buybacks often do nothing more than offset the dilution that occurs when senior executives exercise their options, buying shares at a huge discount to the market and then selling them immediately to lock in the gain. In that case, the number of shares outstanding remains largely unchanged. You need to make sure the number of shares outstanding is actually declining.

Also, it’s important to note that companies sometimes announce their “intention” to buy back shares but do not always follow through. The financing or cash flow may not be available. Industry conditions may take a turn for the worse. Or management may simply change its mind.

But when the buyback proceeds apace and the number of shares outstanding declines, it’s a good thing. And, over time, buybacks can be significant. For instance, in 1993 IBM had 2.3 billion shares outstanding. However, by regularly buying back shares in the open market, the number of shares outstanding has shrunk by about

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